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News of the slowest economic growth rate in five years seemed to have little impact on the financial markets. Today the Commerce Department reported that first-quarter GDP for 2007 was 0.6%. That was less than half the 1.3% rate predicted by government statisticians.

The reality of the situation is that Wall Street loves this economic tightrope–as long as the Federal Reserve can keep the economy away from actual recession. Economic weakness increases the odds that Fed officials will feel pressured into lowering interest rates to stimulate economic growth.

Fed Chairman Ben Bernanke has gone on record saying he doesn’t believe the economy will slide into recession this year. But former Fed chief Alan Greenspan said he thinks there is a one in three chance of a recession. The first-quarter’s performance was the weakest since the final quarter of 2002, when the economy was last recovering from a recession. At that time, GDP eked out a 0.2 percent growth rate.

GDP measures the value of all goods and services produced in the United States. It is considered the best measure of the country’s economic health.

Wednesday we got an indication that Federal Reserve officials were expecting this economic downturn. The quotes below were taken from the minutes of the May 9, 2007, meeting of the Federal Open Market Committee (FOMC) released Wednesday. I added the italics.

“In its forecast prepared for this meeting, the staff expected the pace of economic activity to pick up from weak first-quarter growth to a rate a little below that of the economy’s long-run potential for the remainder of this year and to increase at a pace broadly in line with potential output in 2008. The projected gradual acceleration in economic activity largely reflected the expected waning of the drag from residential investment, although recent readings on sales and inventories of new homes had been interpreted by the staff as suggesting that the ongoing contraction in residential investment would continue for longer than previously expected….

“In their discussion of the economic situation and outlook, participants noted that their assessments of the medium-term prospects for economic growth and inflation had not changed materially from the previous meeting. The pace of economic expansion had slowed in the first part of this year, but the recent sub-par performance probably exaggerated the weakness of underlying demand, and the rate of economic growth was expected to pick up in coming quarters. Meeting participants anticipated that real GDP would advance at a pace a little below the economy’s trend rate of growth through the remainder of this year and then pick up to a rate broadly in line with the economy’s trend rate in 2008. Most participants continued to expect core inflation to slow gradually, although considerable uncertainty surrounded that judgment and the Committee’s predominant concern remained the risk that inflation would fail to moderate as expected.”

It is significant to note that Fed officials expected a weak first quarter but are now expecting growth to resume its upward trend. Also significant is the news that some committee members remain concerned that inflation could continue to increase. Keep in mind that inflation is the FOMC’s priority target–its arch enemy. As long as there is any concern about inflation, the Fed is unlikely to reduce interest rates, even if it means allowing the economy to slip into a mild recession.

As long as the Fed can maintain its economic tightrope walk, we can expect stocks to continue their advance. But the markets are likely to react strongly to any evidence that the Fed is losing control of the situation.

The chart below shows how major indices have fared so far this year. Once again we see that the Dow (gold line) and the S&P 500 (blue line) are dominant over the Nasdaq (black line). The Dow and the S&P 500 are at all-time highs and setting records each day they close up. During strong bull markets it is unusual for the large cap indices to outperform the Nasdaq, but that has been a persistent pattern over the past year and I don’t anticipate any immediate change.

Have a great spring weekend. I finally get to take the bulky plastic boot off of my broken leg so I hope I can do something fun to celebrate.

F.S.

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One of the more common topics of interest among market technicians is whether the market (as represented by the major indexes) is overbought or oversold. In fact, there are some analysts who believe the overbought or oversold condition of the market is the major determining factor on market movement. In the midst of a strong market rally that has existed for a year, right now many investors are wondering whether stocks have reached an overbought extreme.

When the market is overbought, that means that the market has been pushed to an extreme level because of a large number of buyers. Oversold is the opposite condition: too many sellers have driven the market to an extreme in the opposite direction. One investment guru I used to work with likened these conditions to a stretched rubber band. He maintained that when the markets reached these extreme conditions, the only alternative was to bounce back in the other direction.

Unfortunately, my experience has shown that financial markets are not as predictable as the behavior of rubber bands.

The analysts who try to identify overbought and oversold market conditions generally use some type of cycle indicator. The theory is that markets move in identifiable and predictable cycles like the ocean tides or heartbeats. The use of a cycle indicator supposedly allows one to identify where the market is in any given cycle and therefore forecast what its next move is likely to be.

After many years of observing cycle analysis, I can unhesitatingly say that there are periods where it works remarkably well and other times when it is completely wrong.

One of the more commonly used cycle indicators is called a stochastic oscillator. I could devote many pages to explaining how this oscillator works, but that isn’t necessary. All you need to know is that is consists of two moving averages of different durations. When the moving averages cross over each other, that triggers buy or sell signals. The oscillator also includes a scale from 0 to 100. When the oscillator reaches 80 or above, that is an indication that the market is at an overbought extreme and is likely to correct. When it falls below 20, that is an indication that the market is at an oversold extreme and is likely to advance.

Let me illustrate. The chart below shows the daily price activity of Nasdaq over the past six months. The middle portion of the chart with the wavy brown and blue lines is a slow stochastic. I added the red arrows to better show some of the switch points triggered by the stochastic oscillator. One of the first things that becomes obvious is the frequency of the switches. So far in 2007 this stochastic would have produced more than 20 trades. In truth, the oscillator actually did a pretty good job of identifying short-term bottoms and tops. But in most cases it would be impractical for an investor to trade off of this signal because transactions costs would become too cumbersome.

You can also see that the cycles tend to be erratic rather than regular. For example, in April the oscillator climbed above the 80 mark that signifies an overbought market. But instead of correcting and heading downward, the Nasdaq continued to advance and the oscillator generally stayed at an overbought extreme. In the past couple of days the oscillator turned negative again, and the Nasdaq has moved down. But this indicator does not do a good job of forecasting the amplitude or duration of market moves.

Still, it can be a valuable tool for an active money manager, particularly when used in combination with other indicators. The bottom portion of this chart is a moving average convergence divergence (MACD). This is also a tool based on multiple moving averages, but it produces fewer signals than the stochastic oscillator. Right now, it is also turning down, indicating that the market might struggle over the next few sessions.

To get a better idea of what is likely to happen over the short term, let’s take a longer view. The chart below is the same as the one above, except it covers a two-year period. The red arrow is a trendline that I added. My best guess is that the Nasdaq will correct back to that trendline over the next couple of months. That should produce a mostly sideways pattern similar to the period I marked with the blue line. Notice that on the longer-term view this stochastic is too short to be practical as the switch points become almost indistinguishable. The MACD, however, appears to give fairly good trading signals for an intermediate period.

For now the long-term advance by the major indices remains intact. Economic fundamentals remain strong, so it would be difficult for a new bear market to gain a foothold. Although the market appears to be overbought on a short-term basis, any correction here is likely to be sideways and short-lived.

The sharp selling we saw today could well continue Friday ahead of the Memorial Day holiday. But that is likely to reverse next week.

Have a great holiday.

F.S.

Two years ago investors were worried about the impact of a bursting real estate bubble. At the time, I wrote that concerns about a real estate bubble were overstated. I indicated that any bubble was more likely to leak than to burst. Here are a few paragraphs from that article:

“For the most part, those who will be most hurt by a real estate slowdown are essentially the same groups that will suffer in any type of economic recession—those who are overextended, those who earn barely enough to survive, and those who through unforeseen circumstances are forced to sell at an inopportune time.

“They are victims of poor judgment more than of any specific economic factors. People who have overbought big homes using gimmicks like no-interest loans they can barely afford are likely to run into trouble no matter what happens to housing markets.”

I received responses from a couple of readers who essentially indicated that I wasn’t smart enough to understand the depth of the problem or its full ramifications. Today I got a little support from Federal Reserve Chairman Ben Bernanke who said he does not believe a growing number of mortgage defaults will seriously harm the economy.

Bernanke said  that although there would be further increases in mortgage delinquencies and foreclosures through 2008, he does not believe this problem will be enough to derail the overall economy.

“We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system,” Bernanke told members of Congress.

Although there have been plenty of experts who have been warning about a real estate crash for more than two years, the real estate sector has actually remained among the markets’ leaders for much of that time. That finally appears to be changing, but there is still no evidence of a nationwide meltdown like was saw in technology stocks a few years ago.

The chart below shows State Street Global Advisors streetTRACKS Wilshire REIT (RWR) compared to the S&P 500 (gold line). The blue line is a 200-day simple moving average of RWR. Notice that over the past three years, RWR remained above its 200-day MA until just the past few sessions. For investors holding real estate positions, this might finally be the time to bail out.

But as Bernanke indicated, that doesn’t mean the bubble is about the burst. There are many regions where real estate prices are stable or still increasing. As a sector, real estate does not look appealing right now. But overall economic indicators remain strong and other market sectors are taking up the slack.
F.S.

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Today’s market analysis is going to be quite brief, because I’m heavily involved in preparations for an investor trade show next week. Fortunately, the market situation in fairly stable, so there isn’t a lot of new information to report.

Today provided the sharpest drop we’ve seen in the major indices for awhile, and most of the decline was attributed to poor retail sales numbers for April. Many investors remember the correction that began last year about this time and are worried about a repeat performance, but there is nothing to indicate that this will be a serious or prolonged correction. While days like this are certainly uncomfortable, keep in mind that so far this year the Dow (gold line on the chart below) has reached record levels on 21 days. Other major indices have also advanced strongly. Overall market health still looks good.

On the chart above, you can see that the Nasdaq (black line) is still well above its 50-day moving average shown by the brown curved line. On the bottom portion of the chart, the Nasdaq’s Relative Strength Index (RSI) is still trending above 50. Since mid-March the market’s rise has been steep enough that a pullback is expected and normal. The uptrend that began then remains intact. The S&P 500 (blue line) is also holding up fine.

Next week Strategis Financial Group will be exhibiting at the Las Vegas Money Show at Mandalay Bay Resort. Our booth number is 429. Feel free to stop by if you are in the area and we’ll give you a free Indian Head nickel minted between 1913 and 1938.
F.S.

Blue chip indices continued reaching new highs this week, but rising oil prices could soon cause the market advance to falter.

The Dow remains at an all-time high and the S&P 500 is at its highest level since 2000. The black line on the chart below is the S&P 500 and it is easy to see that it finally broke above resistance. The gold line is Merrill Lynch Oil Services HOLDRS Depository Receipt (OIH). Over the past year energy prices are flat, but oil prices have risen steadily since early January.

Last week I forecasted that the major indices would peak in May, then probably either move sideways or gradually correct. The lower two sections of this chart show why I think the indices are near a top. The middle section is a moving average convergence divergence (MACD). The blue line and the brown line on this indicator are showing that the S& 500 is at a highly overbought level.

The bottom portion of the chart is a Relative Strength Index (RSI) and it is also reflecting that the index is overbought. On the basis of these two indicators alone, one could prudently assume that the current market rally is about to run out of steam. But that does not mean that stocks are on the brink of an imminent collapse. Most economic fundamentals remain strong. Because of that we could see a situation where stocks worked off their overbought condition by going sideways.

At this point, the price of oil becomes a major, complicating factor. When fuel costs reach an extreme, it becomes very difficult for the market to advance. High energy costs impact every aspect of the economy. Consumers have less to spend because they have to pay more to drive and to heat and cool their homes. Grocery prices rise as a result of higher transportation costs. The cost of virtually every manufacturing process worldwide increases. The prospect for retail inflation increases and inflation is the greatest enemy of the Federal Reserve.

Businesses are left with the choice of either passing these higher costs on to consumers or bearing the burden of the increase and accept lower profits. Either scenario is bad for the markets. So if the price continues to rise. it could easily create enough pressure to cause the market’s sideways consolidation into a downward spiral.

Oil prices declined today when the U.S. government announced it is suspending purchasing oil for the country’s strategic petroleum reserve. It is hoped that action will remove some of the demand that has been driving prices up for the past few months.

I’m including a couple of links for anyone that might be interested in some historical analysis of oil prices.

http://www.wtrg.com/prices.htm

http://en.wikipedia.org/wiki/Oil_price_increases_of_2004-2006